I just want to make a quick note on the multiplier and the theory of liquidity preference that is not generally recognised. When the full implications of this argument are recognised and integrated with marginalist theories of savings and investment (including the Austrian theory) these theories basically fall apart unless some very restrictive assumptions are put in place.

The Kahn Multiplier multiplies extra income not matched by extra consumable output, and it is of no consequence to the people of one country, seeking a means to increase their own employment, whether that original extra income is generated by the extra output of tools, or of goods for export uncompensated by extra imports, or whether it is a free gift of the government or private philanthropy. Kahn chose road-building as his example, doubtless because it is unnecessary to explain that roads cannot be sold to consumers. (p186)

This gets right to the heart of the matter and Shackle highlights precisely the sentence that is most important so that I don’t have to. When investment is increased new consumer goods do not become available immediately and thus the multiplier effects generate income and consumption that must be matched by the current output capacity of the economy or else they will cause inflation.

Now, here’s the problem for marginalist theory: if the economy is operating at full capacity, as is the typical case in a marginalist model, then how does an increase in investment not lead to inflation? The answer is familiar to any undergraduate who has done his homework: the new investment must be stimulated by a rise in savings. The process here is conceptualised as one in which the causality runs, not from investment to savings, but rather from savings to investment.

Economic actors decide that they will decrease consumption and increase savings. This lowers the rate of interest and investment increases. Thus the multiplier effect that the investment produces is offset by the rise in savings that precipitated the rise in investment (in formal terms cY is offset by sY). Down the road, when the savers go to spend their savings they will find that the extra productive capacity that their invested saving has brought online will allow them to increase their consumption in real terms (i.e. without price increases)**.

Sounds pretty tidy, right? Well, it is… until you introduce Keynes’ theory of liquidity preference. Then the whole thing gets completely mucked up. In simple form the liquidity preference theory states that there exists pools or hoards of money that people hold based on their expectations of the future. When they are optimistic about the future they dump more of the hoards on the market, lowering the rate of interest; when they are pessimistic about the future they extract money from the market, raising the rate of interest.

This means that the rate of interest is no longer governed by the savings desires of economic actors. Rather it is governed by the money markets and the levels of confidence that exist therein. If this level of confidence becomes overly optimistic the rate of interest will be lowered and a boom will be produced. In this boom it is likely that many malinvestments will be made (think of the redundant real estate put in place after the housing boom in, for example, Ireland). These malinvestments will not cater to the desires on the part of savers to consume in the future and since the losses will only accrue to money that would have anyway been hoarded, consumption in the future will outstrip the productive capacity of the economy. Inflationary tendencies will result. In the opposite scenario, we will get deflationary tendencies***.

The key here is that these whims are not the result of some ‘intrusion’ by the central bank, as is the case in the Austrian Business Cycle Theory (ABCT). Rather, they are a natural result of the fact that in the money market it is expectations in the face of an uncertain future that reign supreme. This eliminates the idea of a natural rate of interest that can be arrived at through market processes. The only way of salvaging this notion is to assume some variant of the strong-form Efficient Markets Hypothesis (EMH) in the money markets so that all investors have perfect knowledge of the future and integrate this into their investment decisions.

Given that no Austrian worth their salt would accept this idea, the ABCT falls apart completely. As for the mainstream marginalists, only the New Classicals and the Chicagoites, with their highly artificial theories of the financial markets, have a coherent theory of a natural rate of interest. All the other schools accept that there are imperfections of varying degrees in the money markets. Thus all of these schools implicitly reject the natural rate of interest. But, of course, myopic as they often are, they still continue to use it in most of their models and most of their proclamations about policy. (Even Paul Krugman believes in a natural rate, as do many central bankers).

If we accept that there is no natural rate of interest what conclusion does this lead to? Well, it leads to the conclusion that a central authority should try to lean against the speculative impulses in the market. Given that these impulses are a response to the fact that expectations have to be formed in the face of an uncertain future, the central authority — that is, the central bank — should try to make this future as certain as possible by guiding interest rates. In practice, this is done by controlling the overnight rate of interest.

This is, however, a rather blunt instrument and we have seen in the past that it is not a good means to counteract speculative build-ups in specific sections of the financial architecture. If we accept the above argument then it would be far better for the central authority to intervene in different financial markets directly and give them guidance in accordance with their tendency toward speculative excess. The challenge for central banks moving into the future is to build tools that will allow them to do this. I have suggested what one such tool might be elsewhere. Another challenge will be to start producing the tools needed to try to identify speculative excesses in the markets. This, I think, is one of the biggest challenges that economics faces moving into the future.

___________________

**Actually, the process here is far from simple. The savings must come out of the profits accrued to the new investment. Thus there are some hidden mechanics here that, if they are explored in any detail, may well undermine the argument unless very restrictive and unrealistic assumptions are made. But we will not concern ourselves with this here.

*** Note that these are highly stylised arguments. In reality the dynamics are much more complex. But I am merely taking the models on their own terms here to make the case from within, as it were.

++ I have submitted a paper laying this argument out in far more detail to a journal. If it is published I will try to make it available here in the future for those interested to read.

18 Responses to The Natural Rate of Interest Does Not Exist

“In this boom it is likely that many malinvestments will be made (think of the redundant real estate put in place after the housing boom in, for example, Ireland). These malinvestments will not cater to the desires on the part of savers to consume in the future and since the losses will only accrue to money that would have anyway been hoarded, consumption in the future will outstrip the productive capacity of the economy. Inflationary tendencies will result.”

Are you saying that all investment in this boom will be malinvestment? Say if half of the investment wasnt malinvestment wouldnt this cater to future desires to consume? Why would consumption necesarily outstrip productive capacity in the future? Could it be that extra productive activity exceeds extra consumption?

Every unit of investment must be matched by a unit of future production to accommodate the additional consumption demand that the investment creates. Even if only 1% of the investment demand is malinvestment the system will be out of balance.

As to the reality of the situation… well, we’re not talking about the reality of the situation. We’re dealing with an abstract model. The reality is far more complicated than this.

Just to clarify, the “natural rate of interest” you are referring to here is a monetary rate that clears the market for loanable funds: it equates a quantity of money saved with the quantity of money that capitalists spend on real investment, right?

We have to distinguish this from the Wicksellian “real” unique natural rate of interest: the “real,” non-monetary rate in equilibrium that clears the non-labour factor input markets in a barter economy?

It seems to me that people sometimes confuse these two “natural rates”. I suspect a lot of modern Austrians confuse and conflate them.

Just to clarify, the “natural rate of interest” you are referring to here is a monetary rate that clears the market for loanable funds: it equates a quantity of money saved with the quantity of money that capitalists spend on real investment, right?

Yes. But the real investment must also produce goods and services that meet the additional monetary demand created by said real investment. (This is actually the Harrod-Domar problem and leads to Solow’s famous paper on the production function and hence the Capital Controversies. But I still think we can circumvent this argument by simply pointing to liquidity preference and speculative investment.).

We have to distinguish this from the Wicksellian “real” unique natural rate of interest: the “real,” non-monetary rate in equilibrium that clears the non-labour factor input markets in a barter economy?

I’m not 100% sure that we do. We could imagine liquidity preference in a barter economy too. Say you had a barter economy in which there was one commodity that was used in production, consumption and as a store of liquidity — maybe oil or something. If the hoards of oil were subject to expectations you could easily imagine that people would increase their hoards when they were optimistic and decrease them when they are pessimistic, leading to malinvestment once again.

See the connection here to Sraffa’s point that there are multiple own rates of interest? In order to alleviate this you have to have an arbitrage market with… you guessed it… perfect information. So, we’re back to the EMH which is not very Austrian given that they claim to adhere to Knightian uncertainty.

Regarding own rates and Sraffa, just out of interest, what do you make of Lachmann’s attempt to salvage the natural rate?:

“What is much less clear to us is to what extent Hayek was aware that by admitting that there might be no single rate he was making a fatal concession to his opponent. If there is a multitude of commodity rates, it is evidently possible for the money rate of interest to be lower than some but higher than others. What, then, becomes of monetary equilibrium? … It is not difficult, however, to close this particular breach in the Austrian rampart. In a barter economy with free competition commodity arbitrage would tend to establish an overall equilibrium rate of interest. Otherwise, if the wheat rate were the highest and the barley rate the lowest of interest rates, it would be profitable to borrow in barley and lend in wheat. Inter-market arbitrage will tend to establish an overall equilibrium in the loan market such that, in terms of a third commodity serving as numéraire, say steel, it is no more profitable to lend in wheat than in barley. This does not mean that actual own-rates must all be equal, but that their disparities are exactly offset by disparities between forward prices. The case is exactly parallel to the way in which international arbitrage produces equilibrium in the international money market, where differences in local interest rates are offset by disparities in forward rates”
Lachmann, L. M. 1994. Expectations and the Meaning of Institutions: Essays in Economics (ed. by D. Lavoie), Routledge, London., p. 154.
————-
Doesn’t this idea that “free competition commodity arbitrage would tend to establish an overall equilibrium rate of interest” just assume perfect information and perfect convergence to equilibrium?

And what if certain factor inputs do not have well-behaved demand curves?

Surely Lachmann is retreating into EMH here? (just as you say above!).

Yeah, he is postulating an EMH. Otherwise, as I said, one commodity might be hoarded and dishoarded for liquidity preference purposes. Then we get identical dynamics as I laid out in the post when money is hoarded and dishoarded.

Look at his exchange rates example. In a theory of exchange rates that takes account of speculative dynamics and liquidity preference it is obvious that the value of a currency is not due to some “equilibrium value”. That is why, for example, we saw many currencies collapse in the late 1990s. So, even his example gives lie to his theory.

“When they are optimistic about the future they dump more of the hoards on the market, lowering the rate of interest; when they are pessimistic about the future they extract money from the market, raising the rate of interest.”

This is interesting, because mainstream economics has it the other way around. When agents are pessimistic they all want to save, but nobody wants to borrow, so interest rates fall (not rise) and cash is hoarded.

Whoa, it turns out that the Keynesian idea is bunk. When consumer sentiments drop, so does the interest rate. Of course, I sorta knew this already. Pessimism was quite widespread during the crisis and interest rates plummeted. Claiming the opposite is just stupid.

I got this on my phone when I was walking back from the shop. I thought to myself “If I click on that link will I see the rate for treasuries? I really hope that I don’t”. But, of course, there it is. Staring me in the face.

You’re not only not on the same page as me Pontus. You’re reading from a different book. And you appear to be reading it upside-down. Lol.

I guess this is what passes for Cambridge monetary economics these days. I would imagine that about 4 famed monetary economists just rolled in their graves. 😀

Ah, so you are referring to a different interest rate? Do you mind enlighten us which one you have in mind? You were throughout your piece speaking about *the* interest rate. There is a convention economics by which *the* interest rate is referring to something short-term and riskless, normally 3-month T-bills.

Btw. you’re really obsessed by this Cambridge thing. Not a comment goes by without you mentioning it. Is there some resentment involved here, perhaps?

It’s a model, Pontus. It doesn’t refer to any particular interest rate. If you want to interpret it, I dunno, read Keynes or Harrod or something. Maybe check the TED Spread. I don’t want to discuss monetary matters with you or financial markets as you don’t appear very well informed, to be honest.

Well Krugman, Woodford, and central banks have in mind the 3-month T-bill. And the mainstream theory says that consumer confidence and the short-term interest rate should be positively correlated. At least at a relatively high frequency. And it is.

Most people write models to organise their thinking about the real world. Saying that “it’s just a model” and that there is no real world counterpart is a bit of a cop out (or just bad economics). You have to stick out your neck far enough to put the theory to the test. Otherwise there is no point in theorizing at all.

If I understand you correctly you claim: 1, There is no real world counterpart to the “Keynesian” interest rate, so the theory is unverifiable/unfalsifiable. And 2, positive comovements between interest rates and consumer confidence is not supportive of mainstream theories as this is the central bank trying to counter recessions (which I do not doubt is at least partly true).

Not my model. Classical model. I don’t think it’s any good either. I’m just addressing it. The point is that, even in its own terms it doesn’t work if we have liquidity preference. And that undermines the natural rate argument based on it and used by Krugman, central banks etc.

1. TED Spread is a good approximation. It shows when liquidity preference causes money to flow out of markets due to perceived risk (i.e. what I called ‘pessimism’). It’s what most people in financial markets use to assess market interest rate risk.

2. Central bank wholly controls these rates through OMOs. Again, you’re back to the fact that the model doesn’t represent the real world. Not my fault. I’m just addressing the “pure” model to undermine the “pure/natural” rate of interest theory that arises from it.

Exactly. Perfectly liquid assets like Treasuries should be flooded. Treasuries should be counted basically as cash substitutes, as I said in my post on Piketty. This is because central banks set the rate.

“When they are optimistic about the future they dump more of the hoards on the market, lowering the rate of interest; when they are pessimistic about the future they extract money from the market, raising the rate of interest.”

Yes, exactly. Theory says that it should be anything that isn’t perfectly liquid. I.e. anything other than cash and government bonds. I suppose there is a chance that under certain circumstances people might rush into blue chips (and maybe gold in times of real duress) we would have to do empirical work to establish. I’ve never done it.